Having recently travelled to China, portfolio manager Amit Lodha examines whether the country presents a sustainable investment opportunity, or if it’s just heading for a hard landing.
On a recent trip to China, I arrived with a cautious attitude, only to leave with a renewed sense of comfort in the country’s long-term growth story.
From a macro perspective, there is no doubt that monetary tightening, higher commodity prices and electricity shortages are slowing China’s gross domestic product (GDP) growth.
Credit tightening is having a serious impact on small and medium-sized companies, which will inevitably lead to more non-performing loans in the banking sector.
Automobile sales are weak due to government measures, housing sales are dropping, and a weak domestic stock market points towards tightening liquidity.
There is no question that China’s stimulus programs of 2009-10 led to some significant misallocation of capital, and probably brought forward some commodity demand.
However, to my mind, all this suggests an engineered cyclical slowdown in the pace of growth, designed to control inflationary pressures, rather than signposts on a path to structural decline as some of the China bears would have you believe.
First – a few words on growth. HSBC recently published an interesting timeline that puts the development of various emerging markets into historical context by placing them on a timeline of US economic development1. On this basis, China stands about where the US was in 1941. (Die-hard commodity bulls will notice that India is where the US was in 1882.)
However, what is even more interesting is that China is achieving in a decade what it took the United States 50 years to achieve.
This rapid pace of innovation and productivity growth was apparent during my trip. For example, the Chinese have worked hard to increase the domestic supply of some resources and to bring down costs.
In commodities like aluminium, bauxite, nickel and stainless steel, Chinese companies are innovating, and are – in some cases – more competitive than Western companies.
In manufacturing, the significant size of the domestic market again gives Chinese companies a significant scale advantage, allowing them to invest more in research and development.
Property and consumption
Much has been written about the supposed property bubble in China. My view is slightly more nuanced than some of the recent commentary.
It is true that property prices are towards the top end of their rising trend, in real terms, and the house-price-to-income ratio is high.
The amount of floor space under construction has soared in the past decade, and it is argued that prices need to drop to clear supply.
However, the strong counter-argument is that the total housing stock in China is still short of demand (according to some estimates, by almost 80 million units).
Most of the supply has been at the top end and has been absorbed by investors paying cash (given a lack of other domestic investment alternatives in an era of negative real interest rates), leaving a real shortage in the middle and at the bottom end of the market.
The Government – through its social housing initiative – is trying to set this imbalance right, and over time, this will support commodity demand.
Domestic consumption is also expected to rise significantly, and should therefore remain a positive driver of demand for some commodities.
The Chinese Government has made it clear in its latest five-year plan that it wants to boost domestic consumption and increase levels of social harmony via growth in wages and improvements to the social welfare system.
We should see wage increases across China from the industrialised coastal areas to the rural areas. Notably, the salary increase in rural areas and second tier or third tier cities will be proportionately higher, as these are growing from a lower base.
Hence, my preference overall remains to be invested in commodities that benefit from consumption over capex spending. Copper, energy and potash fit this bill, whilst I find aluminium, steel and iron ore less interesting.
It is also worth noting that if one looks at inventories, unlike 2008, there is limited inventory in the system.
Historically, China has behaved counter-cyclically to the West, and hence, if you see a slowdown in western world commodity demand as commodity prices come off, you could see a restocking in China.
Copper looks to be a beneficiary longer term, thanks to its importance in, for example, air conditioning and car manufacturing. China remains committed to innovation and renewable technologies.
New electric cars, for example, use up to three times as much copper as traditional ones. Cars are largely bought for cash in China, and with fewer than 60 cars per 1,000 people (compared with 750 in the US and an average of 150 in the world), the growth road stretches a long way into the future.
At the same time, copper mine supply remains constrained with high decline rates and significant increases in the cost of mining/production along with environmental/‘not in my backyard’ concerns delaying new supply.
So for me, the main insights from my recent trip were, firstly, that China remains on a structural growth path – even as it tries to navigate a near-term engineered, cyclical slow-down to combat inflation.
The second was that innovation and productivity remain strong, and while rising labour inflation is a worry, increased GDP per capita will drive the economy more towards consumption-driven growth.
Thirdly, as China moves towards becoming a consumption-driven economy (as opposed to the investment-driven growth that it has experienced over the past 10 years), the outlook for consumption commodities (energy, platinum, potash, oil) will be superior to those driven primarily by investment spending (steel, aluminium, iron ore, etc).
For investors, there will be great investment opportunities going forward. Clearly, some of the winners of rising domestic consumption will be local companies whose strong understanding of the local market and the distinctive needs of Chinese consumers will provide them with a competitive advantage.
However, I also expect some foreign businesses to gain from this.
For instance, commodity producers mining the raw materials needed to make the goods Chinese consumers are after, stand to benefit – particularly if the materials are in short supply.
Global consumer names with recognised brands – such as Unilever, BMW, or some of the luxury brands such as LVMH – are likely to continue to see significant revenue growth from this part of the world, as emerging middle classes aspire to new lifestyles.
This is why I think taking a global approach to investing makes a lot of sense nowadays. It ensures that one can capitalise on the investment opportunities presented by, for instance, the emergence of new economic superpowers like China – but not just through local/regional stocks where corporate governance may sometimes be an issue, or where shares may be relatively expensive.
1HSBC. The Southern Silk Road – Stephen King, June 2011.
Amit Lodha is a portfolio manager of the Fidelity Global Equities Fund.
